Communities in economically distressed areas could be deeply impacted by the coronavirus pandemic. For those in Opportunity Zones, recently passed legislation could help encourage investment in their areas.
Key insights
- Investors may find Opportunity Zones have increased appeal after the passing of the CARES Act.
- The CARES Act postpones limits on excess business losses for real estate business activities.
As our nation continues to reel from the effects of the coronavirus pandemic, many communities are hoping Opportunity Zones can continue to bring economic development and growth when they may need it most. Opportunity Zones were designed to bring long-term capital investments into economically distressed communities, while bringing investors temporary deferral and potential exclusion of capital gains. Recently passed legislation has brought change that could positively impact investments in Opportunity Zones.
The CARES Act brings a shift
The CARES Act (the Act) that was recently signed into law contains an estimated $2 trillion or more in stimulus. Along with tax savings opportunities for individuals and businesses, the Act includes a provision that could help support communities that are counting on the Opportunity Zone incentive. The shift comes in how Section 461(l) of the Internal Revenue Code is applied after the Act.
How does Section 461(l) temporarily change?
Prior to the CARES Act, Section 461(l) generally limited losses from real estate businesses in which a taxpayer materially participated. A taxpayer is considered a material participant in a rental real estate activity if they meet one of the tests provided under Section 469 (often referred to as the passive activity rules). These material participation real estate losses, treated as an excess business loss (EBL), were limited to $255,000 for a single individual taxpayer, or $510,000 for a married couple filing jointly. The portion of the losses in excess of the EBL limit had to be carried forward and treated as part of the taxpayer’s net operating loss (NOL) carryforward in subsequent taxable years.
The passing of the Act lifts the EBL limitation for 2018, 2019, and 2020, which means the full amount of a material participation real estate loss may now be deducted in the year the loss was created. The lifting of the EBL rule could reduce tax owed where investment income (capital gain, dividends, and interest income) would otherwise be taxed. This could also put more cash/liquidity into the economy as a natural outcome.
As an additional outcome, taxpayers who were limited by the EBL prior to the Act may be more inclined to invest in an Opportunity Zone, which could also be a win for Opportunity Zone communities seeking capital.
This is best illustrated by examples
Before the CARES Act
Individual A generates a $5 million deductible rental real estate loss for 2019. In the same year, Individual A generated a $3 million capital gain from publicly traded stock. Under the pre-CARES Act rules, and assuming we are talking about a married filing joint couple, Individual A would generally recognize $2.490 million of net capital gain (assuming no other income, etc.) and pay tax on that gain. The EBL balance of $4.490 million would be available in 2020 and subsequent years, as part of Individual A’s NOL carryforward.
After the CARES Act
Individual A will recognize the entire $5 million loss, which results in a NOL of $2 million and Individual A will pay no income tax. Furthermore, the CARES Act allows this individual to carry the $2 million loss back five years and capture tax that may have been paid. This reduces the tax that would otherwise be paid based on pre-Act rules and instead creates a potential tax refund based on the net loss of $2 million.
Investing in an Opportunity Zone after the CARES Act
Individual A makes a $3 million Opportunity Zone contribution. As a result, Individual A’s entire real estate loss of $5 million can be carried back five years. Individual A is then looking at a potential tax refund that is 250% greater than it would have been otherwise and the Opportunity Zone contribution moves capital into an area looking to grow its economic base. The contribution should also help stimulate the economy, which is the primary goal of the CARES Act.
How we can help
At CLA, we have a team of professionals dedicated to understanding the complexities of Opportunity Zones and their related investment and tax implications. We’re here to support you.
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